Tax on Principal Forgiviness

Folks underwater holding their breath

It appears Congress will extend a tax-relief program for them, but not until after the November elections.

WASHINGTON — Congress is back from its summer vacation, so the burning financial question on thousands of homeowners’ minds is this: Are you guys finally going to help consumers who are underwater on their mortgages, many of whom face crushing federal tax bills if they accept — or have already accepted — principal reductions by their lenders?

This question is especially sensitive after the $16.65 billion toxic-loans settlement Bank of America and the Justice Department reached last month. Roughly $7 billion of the deal is earmarked for direct borrower relief, and a large chunk of that is expected to involve principal write-downs for underwater owners.

Earlier settlements with JPMorgan Chase and Citigroup also included debt reductions.

But here’s the problem: Under current tax law, when most of these owners accept reductions in what they owe, the amount the bank forgives gets reported to the IRS, and the owner is hit with taxes as if it were ordinary income.

Congress created a temporary exception to this tax-code rule solely for distressed homeowners — the Mortgage Forgiveness Debt Relief Act of 2007 — but that law expired Dec. 31 and has not been renewed for principal reductions during 2014, whether they are obtained through loan modifications by lenders, short sales or foreclosures.

If Congress does not extend the law retroactively, according to U.S. Attorney General Eric Holder, “hundreds of thousands” of underwater owners could be hit with tax burdens they may not be able to handle.

Equally troubling, the nine-month lapse in the debt-relief act already has prompted large numbers of owners to avoid the possibility of a huge tax bill altogether.

Deeply in the hole on their mortgage debt, they have opted for bankruptcy rather than trusting Congress to renew the law.

“I’m seeing a lot more bankruptcies because of (the expiration),” says Kevin Tolbert, a real-estate agent with Keller Williams in Port St. Lucie, Fla., who has specialized in helping underwater owners do short sales.

Tolbert estimates he handled more than 300 short sales from 2010 through 2013, but he has avoided them this year.

With the potential for heavy tax levies on clients who opt for principal reductions, Tolbert says, until Congress renews the law “I really can’t recommend” that owners take the chance.

Nor can he recommend they declare “insolvency” under the tax code to avoid having to pay money to the IRS.

So back to the main question: What’s happening in Congress on mortgage-debt forgiveness? It’s complicated. Before heading out for summer vacation, it appeared action was imminent in the Senate.

The Finance Committee approved a so-called “extenders” bill that would have renewed the debt-forgiveness law along with 50-plus other expired tax-code programs such as credits for alternative energy and for research and development.

But before a vote was taken by the full Senate, Majority Leader Harry Reid, D-Nev., prohibited consideration of a Republican-backed amendment that would have repealed an excise tax on medical devices that is a source of funding for the Affordable Care Act. That knocked the entire extenders bill off track.

Capitol Hill sources say Reid now wants a vote on the extenders — and is willing to take up the Obamacare amendment — but plans to delay action until the lame-duck session after the November elections.

Since the extenders bill has bipartisan support, it has a good chance of passage then.

On the House side, Ways and Means Committee Chairman Dave Camp, R-Mich., is not likely to schedule a separate vote on mortgage relief, sources say, but he won’t block a short-term extension of the program if the Senate passes the extenders bill in its current form and sends it to the House.

So what’s the outlook for owners scheduled to receive principal debt reductions from banks in the coming months, along with others who have completed short sales or loan modifications this year?

Thousands of Bank of America borrowers covered by the August settlement have some little-publicized special protection: The settlement requires the bank to set aside $490 million to help defray portions of customers’ tax bills in the event Congress fails to extend the relief law.

For most other underwater borrowers who plan to receive principal reductions this year or already have, it’s still nail-biting time.

But the odds for eventual renewal by Congress — yes, even this Congress — appear to be a little better than even.